The Federal Reserve and the banks join forces against Blanche Lincoln's derivatives proposal

The banks, of course, aren't big on Blanche Lincoln's idea to spin derivatives-trading desks out of the banks. Particularly the big banks, which as you can in the graphic atop this post, pretty much control the market. But it turns out the Federal Reserve is on their side. According to the Wall Street Journal, "the Federal Reserve over the weekend tried to kill the provision," sending lawmakers a letter saying the idea should be "deleted" from the bill. But as it is, the idea actually appears to be gaining ground, moving from some weird regulation that Lincoln proposed and nobody expected to part of the actual bill.

The easy explanation is that derivatives-regultion is popular and no one want to stand in its way. But the new Washington Post-ABC poll complicated that story. Though financial regulation is very popular and Obama is far more trusted on the subject than the Republicans, opinions on regulating derivatives are split, with 43 percent supporting federal regulation of the derivatives market and 41 percent opposing it. And derivatives were pretty much the only item in the poll where the skeptics were even close to the reformers.

Really? The average guy, conservative or liberals, thinks keeping it easier to obscure what people are buying and selling, insulating these particular financial instruments from natural market forces, and helping hide when complicate financial schemes are about the blow up in the average investors, pension-holder, and tax payers face . . . they're conflicted about that?

Blanche Lincoln's proposal, like it or not, seems to be the single most serious proposal in the entire FinReg "We're gonna stick it to Wall Street--wink, wink, nudge-nudge, see you at the next fundraiser, Fat Cat--because our constituents demand it!" proposal.

Back in 1997, Businessweek noted that "In the absence of a blowup, practitioners seem more focused on the good rather than the bad and the ugly," continued by noting that "To date, none of these deals has blown up, experts insist. Still, they recognize that the new market isn't without potential minefields" and concluded "For now, practitioners can only hope that when it comes to credit derivatives, Murphy's Law doesn't apply."

That was all back on July 21, 1997, when
"dealmakers and regulators alike" were "ebullient about the potential of credit derivatives for dispersing credit risk," but acknowledged "that in the wrong hands, these instruments can--and most likely will--inflict heavy losses on some banks, companies, and investors."

The names -- of the banks and the regulators -- in the story (http://www.businessweek.com/archives/1997/b3536094.arc.htm) haven't really changed. So whose hands are the wrong hands to control these financial instruments?

Trying to keep the legs of the unified theory together - is the main relevance of the Volker Rule that it would have led to less securitization of mortgages? Or is it better to think of that as separate from the derivatives issues?

However, when that question is asked of people who make >$100,000 per year, the MAJORITY of these Americans SUPPORT this legislation.

If it is explained to people then people will support it.

I actually think that the STRONGEST portion of the bill IS the derivatives language. I suspect in the end that that specific Lincoln language may be taken out to bring in the 10-12 Republican Senators in to vote for the bill.

I agree MosBen. I'd like to know if those answering these questions are qualified to speak on the subject.

That being said for those of us that don't have the subscription to the WSJ what the Fed's reasoning was behind continuing to let it go unregulated is, or at least have them admit the reason. Seems to me Bernake should sit right next to Blankfein at today's meeting.

Many of the Regional Feds are basically in league with the banks and much of the leadership comes out of banking. And of course spinning off derivative trading weakens the Feds power and gives more to the SEC.

In addition, there are legimate hedging reasons for banks to use swaps. They are extremely useful tools to manage interest rate risk. Banning those operations would increase banks exposure to sudden interest rate movements. On the other side of the coin, its very hard to distinguish risk management positions from directional trades.

The only reform necessary for dervivatives is a clearing house and a real requirement for collateral to be posted, so banks can't get away with barely funding their positions. Clamping down on leverage goes a long way towards mitigating risk.

I think the very striking thing about this figure is the derivatives contracts to assets ratio. For JP Morgan, they have contracts worth nearly 50 times their assets, and that's only for one instrument!

How much capital would the banks need to raise in order to keep their contracts if the portion of the bill requiring collateral were to pass?

The Banks do not want people to understand what derivatives are. They are paper backed by paper, and have no value in their own right.

Besides, look at the Banks and understand these are the Banks that own most of the stock in the Federal Reserve Banks. Why wouldn't the Federal Reserve Banks back them, since they make profits whether the average investor is bilked or not.

Another important provision that should go into that regulatory piece is one that identifies every major stockholder in every financial institution, both public and private that does business in this country.

Look carefully at the stockholders of these huge Banks, and the stockholders in the Federal Reserve Banks, and you will see a very clear reason why the Federal Reserve is taking the sides of the Banks against the consumer.

The appeal of the Blanch Lincoln proposal (to me) is it's one of the few surprises in the whole process. The predictability of this kabuki piece where "the financial industry" gets spanked by "government" is to me prima facie evidence that it's not a very hard spanking. And that ticks me off.

To achieve a good result against a powerful opponent, disrupt the predictable flow of events. Make them play outside their script. The SEC case was the best move so far in this regard. So I'm all for any disruptive surprise that plays havoc with our oh-so-lame legislative process. I mean seriously, US Congress vs. Goldman Sachs? Who do you think is favored in that matchup? Let’s see some weirdness people! Proposals to tax transactions, criminal indictments, trot out Volker some more, go find John Bogle and get him to testify about what should be done, tell Buffet you’ll give him his $8B exemption if he’ll go public and suggest something that will cost the industry $80B. The less predictable and faster this all happens, the better.

Yep, I’ve given up believing our congress can thoughtfully craft good legislation that can survive a vote. What a bummer.

I actually just commented on this post at my blog, which is at www.gregthecollegestudent.wordpress.com.

Basically, I tend to think that Ezra's citing of public opinion about derivatives is kinda meaningless. Most people don't really know what derivatives are, or their role in destroying the economy at large, so we need to take public opinion polls about them with a grain (or gallon) of salt.

Reading about polls like this reminds me of that great catch by Michael Kinsley back in the 1980s who reported on a poll asking the American people if they thought President Reagan's cancer would recur.

Opacity reduces scrutiny and confers power on the few with the ability to pierce the veil. Although derivatives have indeed become extremely complex, in actuality, they are as old as the idea of finance itself. The credit derivatives market should borrow a thought from Leonardo: “Simplicity is the highest form of sophistication.”

For a clearer understanding of subprime mortgage-backed credit derivatives, visit: